How to Calculate CAPM for Securities

The CAPM formula calculates the likelihood of specific stock market returns in relation to risk. By applying this formula to each of the securities and assets in your market portfolio, you can better assess the level of risk you take as an investor and whether the potential reward is worth it. Learn more about this concept in corporate finance and investment.

What Is CAPM?

The Capital Asset Pricing Model is abbreviated as "CAPM" by financial analysts. This model enables investors to follow one of modern portfolio theory's most important precepts: knowing a security's risk-free rate allows you to extrapolate how well the stock return will increase in relation to risk. The same is true when assessing other assets such as government bonds and US treasury bills.

How Does the CAPM Work?

CAPM calculates the cost of capital against systematic risk and the possibility of return. It does so by calculating the expected return on an asset using risk-free rates, market risk premiums, volatility or beta variables, and so on.

CAPM can help investors predict how each asset in their portfolio will perform in the long and short term. Investors are more likely to take on assets with a higher risk of loss if they can also be assured that they have the potential for a higher return.

This enables investors to construct portfolios with manageable risk. CAPM may indicate that some stocks will likely outperform the market, while others will likely stay the same or underperform the market. Taking all of this into account, investors can use more stable and reliable investments to hedge against high-risk (and potentially high-reward) assets.

CAPM Formula

The CAPM formula must be used to calculate the expected return on assets: expected return = risk-free rate + volatility/beta * (market return - risk-free rate). Keep the following steps in mind for additional assistance in using this formula:

1. Assess your asset's risk-free rate. Begin by calculating the risk-free rate of return on a specific stock. This is the amount of interest you would expect to earn on your asset in a risk-free environment. This variable will now be used in two places.

2. Determine the difference in your market risk premium. Determine which overall market return metric you want to use to calculate your market risk premium. You could use the total percentage of growth of the S&P 500, Dow Jones Industrial Average, or another relevant market. Subtract your risk-free rate percentage from this variable's market return. The distinction is your market risk premium.

3. Multiply the market risk premium by volatility. Calculate the product of your market risk premium and the beta of the stock (or volatility). This risk measure indicates the amount of risk the stock would expose you and your portfolio to in the real world. This is the point at which CAPM transitions from the theoretical to the practical.

4. Resolve the issue. You'll finish by multiplying the risk-free rate by the product of your market risk premium and volatility. This will give you the stock's required rate of return (or discount rate). You can then decide whether you want to take the specific risks associated with purchasing the asset in question.

Advantages of the CAPM

The CAPM formula includes some advantages for investors and financial professionals. Here are a few to think about:

1. Investment motivation: CAPM helps you understand the weighted average cost of capital (WACC) in general, as well as the time value of money in your own portfolio, among other important financial factors. As a result, it provides risk-averse investors with a little more assurance that the reward of the stock itself, as well as portfolio diversification, will outweigh any potential losses.

2. Portfolio diversification: Different asset classes”and, for that matter, different individual assets”have varying levels of inherent risk. The CAPM formula provides investors with a potentially accurate estimate of the expected returns on all of their individual stocks. As a result, they may be able to diversify their portfolios.

3. Risk management: Using the CAPM formula to calculate any additional risk allows you to see if your portfolio will adhere closely to the capital market line (CML) and security market line (SML) (SML). Both of these metrics indicate that a specific asset is performing at or above the market average.

Limitations of the CAPM

Unfortunately, the CAPM model has a few flaws. Think about the following drawbacks:

1. Assumption of constancy: The CAPM makes the presumption that the present value of stock prices and other variables will stay constant long enough to forecast future financial behavior. Investors have learned from history time and time again that there are very few things in the financial markets that are constant, whether it be interest rates, stock performance, or pretty much anything else. Numerous things are changeable. You may be subject to greater risk and loss as a result than you had anticipated.

2. Fluctuating variables: Every percentage is susceptible to change, so you can only infer so much from an asset's recent and historical performance, as well as the market as a whole. Contrarily, CAPM makes the assumption that the formula's variables won't fluctuate and will be able to forecast future cash flows and asset performance. Because of this, using CAPM too frequently can be dangerous.

3. Lack of information: There are many variables left out of the equation in this type of financial modeling. The performance of an asset can be impacted by a wide range of additional stock market-wide factors that CAPM ignores. The same is true for numerous types of irrational risk.